A credit linked note (CLN) is a bond issued to an investor, which is payable not just depending on the credit risk of the CLN issuer, but also that of a reference asset (e.g. a conventional bond). The CLN will have the same maturity, coupons and principal amount as the reference asset. The CLN represents a commitment by the CLN issuer to make the specified repayments as long as a credit trigger event does not occur.

The CLN issuer will also usually sell protection using a CDS on the reference asset, to a third party, thereby generating an income stream of “CDS premiums” to itself.

What if no credit event occurs?

Provided no credit event occurs with the CLN issuer or the reference asset, the bond’s repayments (coupons and maturity amount) will continue as scheduled until the end of its term; and the CLN issuer will continue to receive the CDS premiums.

What if a credit event occurs?

If a credit event occurs on the reference asset, the CLN issuer either: receives the impaired reference asset from the third party, and then either

gives the impaired reference asset to the investor; or

pays the value of the impaired reference asset to the investor.

The CLN issuer pays the third party the principal amount, as per the CDS.

What is the reference asset?

There are many alternatives:

In its simplest form the original asset would be a conventional bond.

Another alternative is that the reference asset is a pool of 5 bonds from 5 different companies of $20m each; so the pool consists of $100m.

If the CLN issuer wants protection against a foreign country, the reference asset could be a government bond issued by the foreign country.

Whilst synthetically producing cashflows related to an original asset, it’s possible to make changes to adjusting the characteristics of the original asset.

Who is who?

Looking at the arrangement from a credit perspective, the issuer is going short credit risk, and transferring it to the investor. From this perspective:

The investor is also known as the credit “protection seller”.

The CLN issuer is also known as the credit “protection buyer”. This is usually a bank. The bank (protection buyer) may have set up an SPV which is bankruptcy remote from the bank/protection buyer, and bought a CDS from the SPV. The attraction of the bankruptcy remote structure is that the amount paid by the investor to the SPV cannot be claimed by the bank/protection buyer should the bank/protection buyer run into trouble.

Note also that the amount of possible protection has been paid by the protection seller to the protection buyer in full in advance, so the protection buyer carries no credit risk.

Credit Events

Credit events on the reference asset may include:

Bankruptcy/insolvency

Repudiation

Failure to pay a coupon

Cross-default

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Is a CLN a Bond or Derivative?

A CLN is a debt note / debt security / bond with a specified notional amount. The fact that it is a bond makes it attractive to investors who are not allowed to hold derivatives.

Universe of Credit Derivatives

Although technically not a derivative, credit linked notes are often grouped together with Credit Default Swaps (CDSs) and Total Rate of Return Swaps (TRORs) as the instruments with which to manage credit risk.

Benefits to the Parties

Benefits to the investor

The investor’s motive is to obtain a return higher than he would attain if he invested directly in the reference asset, to compensate for the additional credit risk taken on (his return depends also on the CLN issuer not going bust). Something the investor should also consider, is what the correlation is between the reference asset going bust and the CLN issuer going bust – if the correlation is high, then the investor should demand a higher additional return.

Benefits to the issuer

Most issuers are issuing CLNs to reduce existing counter-party risk on their balance sheets – the CLNs are frequently banks wanting to reduce exposure to their corporate clients. The advantage of CLNs over CDSs and TRORs, is that credit risk can be reduced without adding credit risk to another party.

The CLN allows the issuer to raise funds.

Is there any reason why an SPV is created for a CLN but not for a CDS?

A credit-linked note often has an accompanying CDS in the structure.

Let’s say an investment bank is seeking the protection – this is often the case.

The SPV will have invested the principal it had received from the investor in exchange for the CLN into, say, government bonds; which serves as security for the CLN and for the CDS which the SPV has written to the investment bank.

The classical setup is that a bankruptcy remote SPV is created so that if things go wrong with the investment bank it cannot go after the assets of the SPV, and the investor is not impacted.

The attraction for the investment bank of this structure over a CDS is that the guarantee is prefunded by the principal payment to the SPV; whereas under a conventional CDS (ie, without an accompanying CLN), the investment bank is taking on more counterparty credit risk.